Feb. 26 (Bloomberg) -- Federal Reserve Chairman Ben S.
Bernanke’s efforts to rescue the economy could result in more
than a half trillion dollars of paper losses on the central
bank’s books if interest rates rise abruptly from recent levels.

That sum is the difference between the value of securities
in the Fed’s portfolio on Dec. 31 and what they may fetch in
three years, according to data compiled by MSCI Inc. of New York
for Bloomberg News. MSCI applied scenarios devised by the Fed
itself for stress-testing the nation’s 19 largest banks.

MSCI sees the market value of Fed holdings shrinking by
$547 billion over three years under an adverse scenario that
includes an economic contraction and rising inflation. MSCI puts
the Fed’s mark-to-market loss at less than half that, or $216
billion, if the economy performs in line with consensus
forecasts of gradually rising growth, inflation and interest
rates.

The potential losses are unprecedented in the Fed’s 100-year history. Bernanke began describing in detail the risk of
lower payments to taxpayers for the first time today in his
monetary policy testimony before the Senate Banking Committee
saying that “remittances to the Treasury could be quite low for
a time” if interest rates “were to rise quickly.” Bernanke
didn’t describe the overall interest-rate risk to the portfolio
or potential mark-to-market losses. He said the Fed is
“confident” it has tools to tighten monetary policy.

Where’s Money?

“You can easily imagine a naive congressional response,
which is ‘Where did the money go?’ ” said Sarah Binder, a
senior fellow at the Brookings Institution who researches the
relationship between the Fed and Congress. “Even if there’s a
perfectly logical explanation and the normalization of the
balance sheet is a good thing in the long term, the headlines
will probably generate congressional scrutiny,” said Binder.
“That’s never a good thing from the Fed’s perspective.”

The risk of mark-to-market losses under some scenarios is
the price of Bernanke’s battle to overcome the deepest recession
since the Great Depression as the Fed embarked on three rounds
of so-called quantitative easing. The benefit is more jobs and
higher growth, Fed officials say.

“To the extent that monetary policy promotes growth and
job creation, the resulting reduction in the federal deficit
would dwarf any variation in the Fed’s remittances to the
Treasury,” Bernanke said in today’s testimony.

Corker Inquiry

Senator Bob Corker, a Republican from Tennessee, sent
Bernanke a follow-up letter this afternoon asking for the
central bank to provide further details about how losses would
affect the Fed’s operations.

“Do we have a serious policy problem brewing here, or is
this simply an optics problem about which we should not be
concerned?” Corker asked.

The Fed doesn’t mark its portfolio to market, and its
losses may be only a fraction of MSCI’s totals because the
central bank could hold the bulk of its assets to maturity. The
central bank cannot go bankrupt and can continue to operate with
losses on its books.

“There’s a cost to very significant stimulus -- and that’s
OK if the stimulus is a good investment -- and I think a lot of
what the Fed has done is a very, very good decision,” said
Representative John Delaney, a Maryland Democrat and member of
the House Financial Services Committee, where Bernanke testifies
tomorrow. “Their actions right now are having diminishing
returns and increasing the severity of this future loss that
will be incurred as rates go up.”

Bernanke’s Legacy

Bernanke’s legacy will be judged in part by how the Fed
exits from its emergency policies, a prospect that is already
troubling the Federal Open Market Committee and some members of
Congress. Bernanke, 59, ends his second four-year term as Fed
chairman on Jan. 31, and he hasn’t said whether he wants to stay
in the job after that.

Four economists, including Frederic Mishkin, a former Fed
governor and co-author with Bernanke, argued in a paper
presented in New York on Feb. 22 that the central bank’s grip on
policy may weaken if losses coincide with high U.S. budget
deficits and an inability of Congress and the White House to put
fiscal policy on a sustainable path.

“This mix could induce a bias toward slower exit or easier
policy, and be seen as the first step toward fiscal dominance,”
the economists said in the paper, presented at the U.S Monetary
Policy Forum, referring to fiscal influence on monetary policy.
“It could thereby be the cause of longer-term inflation
expectations and raise the risk of inflation overall.”

Fed’s Flexibility

In response, Fed Governor Jerome Powell said at the
conference that policy makers “have the flexibility to
normalize the balance sheet more slowly” to avoid taking losses
and causing market disruptions. He said there’s “no reason” to
expect the Fed won’t act to prevent inflation.

Boston Fed President Eric Rosengren said that “this
discussion does not do justice to the policy trade-offs” of the
central bank’s quantitative easing, because the stimulus boosts
growth and also improves the fiscal outlook by lowering
borrowing costs.

Now, it’s Bernanke’s turn to convince lawmakers.

“When they start losing money -- that is going to be a big
issue” on Capitol Hill, said Hester Peirce, a former senior
counsel to Republican staff on the Senate Banking Committee who
is now a senior research fellow at the Mercatus Center at George
Mason University in Arlington, Virginia. “There will be more
pressure to watch the Fed closely.”

Bernanke is implementing the most aggressive monetary
policy in the central bank’s history to support growth and
employment. After the Fed’s benchmark rate was cut to a range of
zero to 0.25 percent in December 2008, the chairman began buying
more bonds to lower longer-term financing costs for home buyers,
companies and consumers.

Total Assets

Three rounds of quantitative easing, including the current
phase where the Fed is buying $85 billion in longer-term
Treasury bonds and mortgage-backed securities a month until the
labor market shows substantial improvement, have pushed the
Fed’s total assets to more than $3 trillion, from $869 billion
in mid-August 2007 when the financial crisis began.

Fed officials say the portfolio’s size and even potential
losses are a byproduct of its pursuit of stable prices and
maximum employment, the two policy goals mandated by Congress.

At the same time, they have encouraged the public to view
the portfolio in profit-and-loss terms by emphasizing its
earnings in recent years. Officials in conference calls with
reporters describe how returns on the expanding balance sheet
have generated higher profits that the Fed gives back to
taxpayers in the form of remittances to the U.S. Treasury. Vice
Chairman Janet Yellen, in Feb. 11 remarks in Washington, said
the strategy benefits the economy as well as federal finances.

The Fed’s cost of funds is low because there is no interest
expense for it to issue currency, and it pays banks just 0.25
percent on reserves the central bank creates to buy assets. This
helps maximize the return on the Fed’s portfolio.

After paying for its own expenses and making capital
adjustments, the Fed returns the remainder of its earnings to
U.S. taxpayers. The Fed remitted a record $88.9 billion to the
Treasury in 2012 and $75.4 billion in 2011, compared with $31.7
billion in 2008.

Enriching Treasury

The earnings that are enriching the Treasury now may shrink
as interest rates rise, driving down returns from the Fed’s
holdings. Remittances may even disappear for a few years,
according to Fed researchers who published a paper on the
balance sheet last month.

At the same time, the Fed’s portfolio will be shrinking in
value as the higher rates erode the market price of the
securities it contains.

Representative Jim Jordan, an Ohio Republican who chairs a
subcommittee of the House Committee on Oversight and Government
Reform, asked Bernanke in a Feb. 19 letter for more details
about the portfolio’s risks.

“Such a large portfolio could cause significant problems
when the Federal Reserve begins to unwind,” he said in his
letter.

Sustained Growth

“The Federal Reserve has played and is currently playing a
major role in fostering the sustained economic growth we’ve seen
over the past few years,” said Matthew Cartwright, a
Pennsylvania Democrat and ranking member on the House Oversight
Committee’s subcommittee on economic growth, job creation, and
regulatory affairs. “The role of the Federal Reserve is to
stabilize the economy and help it grow at a healthy rate through
the enactment of monetary policy, balancing interest rates with
unemployment--its role is not to make money.”

The Fed’s own exit strategy calls for selling mortgage-backed securities after it begins to raise interest rates. The
Fed only records a loss on its bond holdings if they are sold.
If losses from bond sales, and the interest the Fed pays to
banks to fund its assets, exceeds income, the Fed accounts for
it as a “deferred asset.”

Political Backlash

“The political backlash could be particularly acute given
that a good portion of the funds that would otherwise be
remitted to the Treasury would be transferred to large financial
institutions in the form of interest paid on reserves,” said
Laurence Meyer, a former Fed governor and co-founder of
Macroeconomic Advisers LLC in St. Louis. “This could present a
significant communication challenge for the Fed and adversely
impact its reputation.”

MSCI calculated potential losses and gains to the central
bank’s portfolio by running the same three scenarios the Fed is
using this year to stress-test the capital of the 19 largest
banks.

The baseline scenario is similar to a consensus forecast
for the economy’s performance in which growth continues. Under
the adverse scenario, the economy contracts for six quarters
while inflation rises, with the consumer-price index reaching 4
percent. In a severely adverse scenario, the economy falls into
a deep recession and interest rates decline.

MSCI provides investment, analytic and risk-management
tools to some 6,200 clients around the world, operating in 22
countries with more than 2,700 employees. Its products include a
suite of portfolio-risk and performance analytics, stock indexes
and corporate governance tools such as proxy research. One of
the firm’s brands, RiskMetrics, developed the widely-known
value-at-risk model, or VAR, in 1994.

10-Year Yields

MSCI’s data showed the greatest losses under the adverse
scenario, as 10-year Treasury yields jump to 5.4 percent by the
end of 2015 and three-month rates rise to 4 percent. The 10-year
yield was 1.86 percent yesterday, and the three-month rate was
0.117 percent.

Because the Fed deliberately lengthened the maturity of its
portfolio by selling short-term notes and bills and buying bonds
from September 2011 until December 2012 in a program dubbed
Operation Twist, “Treasury performance dwarfs what is happening
in the other books” of agency and mortgage debt, said Ron
Papanek, executive director of MSCI.

“They have a lot of long bonds that are going to be hit in
a rising rate environment,” Papanek said.

Portfolio Loss

Losses on the Fed’s portfolio rise steadily under the
adverse scenario to $547 billion by the fourth quarter of 2015
in the MSCI analysis, which is purely a measure of interest-rate
risk in the portfolio starting from bond prices at year end. It
does not take account of purchases or sales the Fed may conduct
in the future. The calculations are mark-to-market losses on the
portfolio that take account of yield, amortization, accretion,
and funding costs.

The Fed portfolio also loses money under the baseline
scenario, in which economic growth accelerates to a 3 percent
annual pace in the final quarter of 2015 and the inflation rate
is 2.4 percent. This compares with Fed officials’ own estimate
of 3 percent to 3.7 percent growth in 2015 and inflation of 1.7
percent to 2 percent. With three-month Treasury bill rates at
1.9 percent and 10-year yields at 3.9 percent, the Fed’s
portfolio losses rise to $215 billion in the fourth quarter of
2015, according to MSCI’s analysis.

Because the Fed’s severely adverse scenario envisions a
deep recession, little movement in short-term rates and a
gradual rise in long-term rates, its portfolio posts a mark-to-market gain of $84 billion by the fourth quarter of 2015 in
MSCI’s analysis.

Some Fed officials are wary of how the central bank intends
to account for the losses and how Congress might react.

‘Appearance Issue’

“I am concerned about this issue,” St. Louis Fed
President James Bullard said in a Feb. 1 interview in
Washington. Bullard advocates holding some remittances back in
the form of reserves now to serve as a buffer against losses
later. “The appearance issue is a serious one and we should
take it seriously,” he said.

The practice of accounting for losses as a deferred asset
is among questions congressional leaders are raising.

“I don’t think we will buy that,” said Republican
Representative John Campbell of California, a certified public
accountant who chairs a monetary policy subcommittee on the
House Financial Services Committee. Fed portfolio losses are “a
legitimate concern and something we will be watching.”

Fed officials say the portfolio losses should be viewed in
comparison with the Fed’s cumulative remittances to the
Treasury, which have totaled $448 billion over the past decade.

Staff Paper

In the past, officials have warned that they are taking on
interest-rate risk, and a recent paper by Fed Board staff
attempted to quantify how that would affect their payments to
the Treasury.

The analysis led by Seth B. Carpenter, senior associate
director in the Fed Board’s Division of Monetary Affairs, shows
that, assuming another $1 trillion of bond purchases under the
current quantitative-easing program, remittances to the Treasury
will fall to zero for about four years under a baseline economic
outlook with gradually rising interest rates.

The Fed’s portfolio had $249 billion in unrealized gains as
of the end of September, according to the paper.

Under a more aggressive interest-rate increase scenario,
remittances are halted for about six years, as “higher short-term interest rates make interest on reserves more costly, and
higher long-term rates make selling MBS more costly,” according
to Carpenter’s analysis.

Yellen Speech

“There is a chance when we could go through a period of
time in which our income falls and we could even take losses if
we decide to sell,” Yellen said in response to audience
questions after a Feb. 11 speech. “It is possible that in the
course of trying to carry out monetary policy that there will be
a period of a year, or even several years, in which those
remittances fall to zero.”

Minutes from their January meeting show “many
participants” on the FOMC worrying about how to exit from the
bond portfolio with “several” noting the Fed could be exposed
to “significant capital losses.”

The Fed wouldn’t be the first central bank to lose money
from its policies, said Nathan Sheets, formerly the Fed’s top
international economist.

Central banks in Switzerland, Chile, Mexico have taken
losses that did not prevent them from conducting monetary
policy, he said.

There is a good news side to the story as well, he added.

“It’s often thought that if you incurred a loss you made a
mistake and didn’t handle resources properly,” said Sheets, now
global head of international economics at Citigroup Inc. in New
York. “In central banking that presumption is turned on its
head,” Sheets said.

“If recovery occurs then bond prices may fall,” he said.
“But it’s not a failure in your policy, it would reflect a
success of your policy” as economic growth picks up and the Fed
can finally stage an exit.